Regulator files allegations against Sino-Forest auditor Ernst & Young

The Ontario Securities Commission accused Ernst & Young on Monday of failing in its audits of troubled Chinese forestry company Sino-Forest Corp., which has since collapsed amid allegations of being a massive fraud.

The accusations came as the auditors agreed to a $117-million civil settlement in connection with a class-action lawsuit in the case — a settlement the law firms involved characterized as the largest by an auditor in Canadian history.

The provincial regulator accused Ernst & Young on Monday of failing to conduct their audits of the company in accordance with industry standards.

The OSC has also accused the accounting firm of failing to do enough to verify the existence of Sino-Forest's most significant assets and conduct their audits with a "sufficient level of professional skepticism."

"Ernst & Young failed to adequately respond to a number of unusual facts and findings that came to its attention in the course of conducting the audits of the material financial statements," the regulator said in its statement of allegations.

"These facts and findings should have caused Ernst & Young to treat the representations of Sino-Forest management with greater caution and to perform additional audit procedures and to obtain additional evidence from independent sources."

The allegations have not been proven in court.

The accounting firm said it has co-operated with the OSC throughout the investigation into Sino-Forest.

"We are confident that Ernst & Young Canada's work was conducted in accordance with Generally Accepted Auditing Standards and met all professional standards," the firm said in a statement.

"The evidence we will present to the OSC will show that Ernst & Young Canada did extensive audit work to verify ownership and existence of Sino-Forest's timber assets."

The law firms representing shareholders in a class-action lawsuit against Sino-Forest and others said their clients were pleased with the $117-million settlement.

"We look forward to aggressively prosecuting the action against the remaining defendants," said Kirk Baert, partner at Koskie Minsky which brought the case with Siskinds.

Ernst & Young said it agreed to the settlement without any admission of liability.

"Upon approval, the settlement will reduce the uncertainty and future burden on our business, and allow us to focus on our people and our clients," Ernst and Young said in a statement.

The latest twists in the Sino-Forest case came as the company's creditors approved its restructuring plan under the Companies' Creditors Arrangement Act on Monday. The plan will see its creditors take over the company after 99 per cent of those affected backed the move.

Sino-Forest said it will now ask the Ontario Superior Court of Justice also to approve the plan, which it expects to implement by Jan. 15.

Sino-Forest raised some $3 billion between February 2003 and October 2010 from investors in various issues of debt and equity.

The company was first accused last year of being a massive fraud by Muddy Waters Research, prompting investigations by the Ontario regulator and the RCMP.

Sino-Forest and several former executives have since also been accused of lying to investors and attempting to mislead investigators.

Muddy Waters research director Carson Block praised the OSC.

"We applaud the OSC for holding auditors accountable for their actions, something the accountants themselves should have done when they were looking over Sino-Forest's books," Block said in a statement.

"Unfortunately this situation is symptomatic of a pervasive and global problem: that auditors see their primary duties as being toward management, rather than to shareholders."

Ernst & Young resigned as Sino-Forest's auditor on April 13.

The firm was appointed as the auditor of Sino-Forest in 2007 and audited the company's consolidated financial statements for 2007, 2008, 2009 and 2010.

The OSC alleged that Ernst & Young failed to properly understand the legal basis of Sino-Forest's claim to its assets and relied on an opinion prepared by the forestry company's legal firm Jingtian and Gongchen Attorneys at Law.

"Ernst & Young failed to appreciate and respond to the limitations of the Jingtian opinion," the regulator said.

The OSC also accused Ernst & Young of inappropriately relying on the valuation work of Poyry Forest Industry Ltd., a company hired by Sino-Forest to prepare periodic valuations of its timber holdings.

Sino-Forest, once the most valuable forestry company on the Toronto Stock Exchange, valued at more than $6 billion, has since filed for bankruptcy protection and is working to restructure itself under the Companies' Creditors Arrangement Act.

Last month, the Ontario Court of Appeal upheld a lower court decision that ranked indemnity claims by the auditors and underwriters of Sino-Forest with other equity claims in the company's restructuring.

The appeal court panel agreed the court overseeing Sino-Forest under CCAA was correct in its decision that the claims were equity claims.

The decision puts the claims on a lower priority than other creditors' claims on the company's assets in the restructuring.

Generally, debt holders are first in line to make claims on a company's assets ahead of shareholders, who have an equity stake in the company.

In the case of Sino-Forest, shareholders are not expected to receive anything.

Several class-action lawsuits have been filed against the company, its auditors and its underwriters.

Though none of the proposed lawsuits have been yet certified, an Ontario case is seeking $9.2 billion in damages.

Cases in Quebec, Saskatchewan and New York have not specified the amount of damages sought.

Meanwhile, the U.S. Securities and Exchange Commission launched proceedings against the China affiliates of several of the large accounting firms for refusing to produce audit work papers and other documents related to China-based companies under investigation.